Dealing with investor’s veto rights for startups

Any sensible investor would want to minimise their downside risks when making an investment especially in a risky asset class portfolio such as when investing in an early stage startup. The common way on how this may be achieved is by inclusion of veto rights over certain major company actions.

With the exceptions to angels, families and friends, most financial investors (i.e. people that spend their full time daily as an investor) such as corporates and venture capitals will want to dictate the investment terms before sending the cash over to your business. They will expect some degree of control over board actions in early stage financings.

If you’re raising funds for the first time, you must get a startup lawyer to review the term sheet to make sure the terms are industry standard. Try to negotiate and limit the scope and extent of such control. The worst thing you can do is to accept all the terms without even understanding the consequences down the line.

Back to the veto/control issue. Reserved matters list are usually found inside a shareholders agreement. Veto rights are referring to the ‘reserved matters’ list, namely stuff that relates to the company’s business affairs such as future shares issuances, amendments to the company’s constitution, declaration of dividends or the sale or buyout of any new business or formation of a new subsidiary. In practice, the company (i.e. the management team) will have to seek the investor’s approval before taking any of these actions.

The inclusion of the veto rights by inclusion of an extensive reserved matters list can reduce a founder’s or management’s control over the company.

Many rookie founders make the mistake thinking that they still ‘control’ the company by having a majority of directors on the board. In practice, an investor may just hold 5% in the company but has the power and ability to limit the matters subject to veto rights so long as they are agreed by the present shareholders in the shareholders agreement.

Founders and management should try to limit the matters subject to veto rights, and make the consent procedure simplified (eg, an email reverse confirmation should suffice as opposed to having a drawn out letter on the startup’s letterhead to get the approval). If there are multiple investors in the company, you should negotiate so that only one or two lead investors (or alternatively a majority of the investors) are required to give consent. In reality, an investor may be invested in a portfolio of investee companies while running around assessing deals or deploying capital (if the fund’s investment period is still subsisting) so your approval could take several days or weeks depending on how responsive your investor may be at the time.

In my experience, it is challenging to resist items which may impede the company’s ability to conduct future fundraising rounds, as it is critical that your company’s board has the power to issue shares to raise further company when needed, without an investor having a veto right. The best approach is to grant investors the right of first refusal over any new issuances of shares (in a future fundraising round), rather than a veto. Your startup will need the flexibility to raise future capital without having to get the investor approval, while allowing existing investors the opportunity to subscribe for future shares before they are offered to new investors. At times, I have seen a few early stage investors requesting for an anti dilution clause so that they can manage downside risks of their shareholding if there is a down round (i.e. a scenario in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing.)

As a startup founder, an extensive long list of actions that requires you to seek investor approval will significantly burden a company, and will prevent founders and management team from running the startup effectively.

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